While another Federal Reserve rate cut was a certainty, the outcome of Tuesday’s meeting was still a surprise. In what The Daily Telegraph called “an unconventional move that surprised economists and investors alike”, the Fed chose to ditch its federal funds base rate target for the first time in 75 years in favour of a range set of 0%-0.25% (down from 1% previously). Market reaction was more predictable than the move: stocks rallied, but the US dollar hit a 13-year low against the yen and dropped to its weakest against the euro in 11 weeks. Meanwhile, ten-year Treasury yields fell to just 2.26%, the lowest since 1951.
“This is the lowest the target rate has ever been. Full stop. End of story,” said David Ader at RBS Greenwich Capital. “It’s an amazing event.” The Daily Telegraph’s Edmund Conway agreed: “For the first time in modern history, interest rates are no longer a major tool for the Fed. Borrowing costs are as low as they can go without causing bizarre malfunctions in the US financial system”. But as Ian Shepherdson at High Frequency Economics put it: “So here we are: rock bottom. It’s a reflection of an utterly desolate economic picture which will persist for the foreseeable future as the wrenching adjustment in household finances continues”.
So what do US central bankers have left in the locker? “Policy makers are petrified about the economy sliding into a deflationary spiral,” said Joshua Shapiro at MFR. “Monetary policy is going to do whatever it can to try to avoid this.” Now “the Fed will switch solely to ‘quantitative easing’”, said Capital Economics’ Paul Ashworth. “In only three months, the Fed’s already more than doubled its balance sheet to $2.2trn, and has committed to expand it to at least $3trn, mainly by purchasing ‘large quantities’ of mortgage-backed securities and now possibly Treasury securities as well”. In other words, the Fed will supply lots of money to the markets to try to get banks lending again, and to attempt to kick start both consumption and the collapsing housing market.
That’s going to be a tough job: November’s economic numbers were truly awful, with retail sales slumping 1.8% month-on-month and housing starts falling to a new record low. At least consumer prices dropped a record 1.7% last month, pulling down the year-on-year inflation rate to just 1.1%. So could the Fed’s approach work? The jury’s still out. “America has turned Japanese. This is the thing I’ve been afraid of ever since I realised that Japan really was in the dreaded, possibly mythical liquidity trap,” said Nobel-prize winning economist Paul Krugman. “We’re in very deep trouble. Getting out of this will require a lot of creativity and some luck.”